A jungle of mutual funds

The question that most mutual fund investors focus closely on is which fund they should invest in. This is especially true for new investors. However, this is the wrong question, at least in the beginning. In fact, focusing on getting the answer to this question will inevitably lead us down the path to making the wrong choice. Actually, the most important question is, what type of fund should you invest in. In the parlance of mutual fund investing, which fund category or categories should you invest in. That's the complicated but important question and once that's decided, choosing the exact mutual funds is simple enough. Well, at least it's much simpler.

Note that I have used two distinct terms above while introducing this subject: 'type of fund' and 'fund category'. The two should be the same, but it's not the same. The reason is that fund categorisation is something that is officially defined by the regulator, and the official list of categories is, to put it mildly, a jungle. So how do you hack your way through this jungle? Let's get back to our initial problem.

The reason that choosing a fund is most important is this: when you think about the inputs that go into deciding which fund to invest in, the primary inputs are your financial needs. Obviously, those actually map to a fund category. Then, once that is decided, the next step is the task of choosing which fund in the category is a good one. Like I said, if you have chosen the right category, that's not difficult.

Here's a real-life example that will help you understand the point. Suppose you need to save money for something that will be needed after 10-15 years and you want more returns than what deposit-type options can offer. The obvious choice is the equity category. Within equity, depending on a few other criteria, it would be suitable to have some combination of equity funds that are large and mid-small cap. If you are a new investor starting with a small investment size, all your needs could be met by just one or two hybrid funds. Various principles and thumb rules map from the financial requirement to the fund type. Clearly, a bland reading of the massive official list of categories will not help investors map them onto their own needs. The categories are simply based on where the funds invest in - the type of asset class that the funds invest in.

Fund companies have always worked hard to make their funds unclassifiable. That sounds strange, but there's a clear commercial reason for this. Once there is a classification system, the primary use of that system is to rate, rank and compare funds within each category. Basic marketing wisdom dictates that fund companies should try and differentiate their products so that they can claim that a fund should be evaluated only by its own claimed characteristics and not by comparing it to any other fund. There's nothing new in this - it's just the de-commoditisation imperative that every business has. The problem with the official categories list is that it homogenises the main types of funds and limits each AMC to only one fund of those types. At the same time, it leaves a rather large loophole for fund companies to create an unlimited supply of speciality funds.

In practice, this has not made the investor's task any easier. In the five years since the uniform categorisation system commenced, the old type of confusion has died out, and a new one has taken its place. Experienced investors - those who are sceptical of the funds' marketing machinery - can pick their way through the fog. Value Research also helps by creating a system of mapping investors' actual real-life needs to a cross-section of the official fund categories. This system is incorporated in Value Research Premium and other services. A simplified fund categorisation system is a basic requirement for new investors to understand what they must do and how to do it. Such an understanding is achievable but needs more work than it should.

Suggested read: For investors, the most important decision